Which statement explains why statutory tax rate and effective tax rate might differ?

• A. They are always equal
• B. Differences arise from credits, deductions, and timing differences
• C. The statutory rate is measured after credits
• D. The effective rate ignores deductions

Answer: (B)

The key idea is that the statutory tax rate is the legal rate applied to taxable income, while the effective tax rate reflects the actual tax expense relative to pre-tax accounting income. They can differ because tax law interacts with accounting through three main channels: credits, deductions, and timing differences.

Credits reduce the amount of tax owed dollar-for-dollar, regardless of how much income you report. Deductions lower taxable income, so the tax computed at the statutory rate shrinks as income is reduced. Timing differences arise when income or expenses are recognized in different periods for tax purposes than for financial reporting, creating deferred tax assets or liabilities that affect the current tax expense.

Because of these effects, the amount of tax you actually pay (and thus the effective tax rate) can be higher or lower than the statutory rate. That’s why this statement is the best explanation.